With all the market volatility recently and the S&P near correction territory, investors are trying to find answers. One item that has been targeted is the increase in interest rates recently. Those who buy into this theory say that increasing rates will increase the discount rate on stocks and that will drive prices lower. Just from a competing for your-next-dollar standpoint, it is true that treasuries at 3% look a lot better than <2%.
I have already argued that I am bearish on the notion that interest rates will rise much further from here. I have based that on (i) real long-term interest rates are lower than people probably think, but are skewed by the high rates of 80s & 90s, (ii) demographic headwinds (baby boomers aging will roll into lower risk securities), (iii) technological improvements are a large deflationary headwind, which will keep rates in check, and (iv) global interest rates remain very low compared to the US and the US is the best house in a bad neighborhood, which will drive increased demand for US$. A strengthening dollar also puts downward pressure on inflation.
given rates moved up quickly from their lows to ~3.2%, I wanted to show the impact on this move on a hypothetical company. I have made these numbers up, but used average S&P EBITDA and EBIT margins for my starting assumptions, assumed a 25% incremental margin, and a 27% tax rate. I also assumed capex = depreciation as this example is a mature business and growing only at about GDP (3%).
Here’s a summary below of where it is currently trading and model:
As shown, the company is currently trading around 12x LTM EBITDA (average S&P company trades for 12.5x LTM). Let’s see if this particularly equity looks cheap based on a DCF. I use both the terminal multiple method and the perpetual growth method below.
As you can see, the implied prices I get are right around the stock’s price today meaning the stock is trading for fair value. What’s the downside if interest rates go up 1%?
Well first, we need to access the impact on our weighted average cost of capital, or WACC. I assume the risk free rate is 3%, as it is today, the beta of this stock is 1.1, and the equity risk premium is ~5%, in-line with long-term history. I also assume the cost of debt is ~5.5%. It is important to remember that many company’s have fixed and floating rate debt. As such, a 1% increase in the 10 year won’t actually impact a company with fixed rate debt until they need to reprice it. But for conservatism, I assume it is a direct increase in their cost of debt. Bottom line: I increase the WACC by 1%.
So how does this translate into our company? Well, as seen below in the bottom right box, a 1% increase in the discount rate would have a ~5% impact on our stock value, all things being equal.
Bottom line: Interest rates really have not moved to 4% and so I am skeptical of the 10% correction in stocks today and the increase in rates thus far actually impairing their prospects.
I wanted to take some time to discuss 3 things when investing in Emerging Markets that are not widely discussed. The impetus for this article was driven by my blog post at the beginning of 2018 titled, “How to invest when inflation picks up“, in which I said that because I was bullish on commodity prices, I was going long Brazil. Brazil has a very commodity driven economy (oil, metals & mining, agriculture) and my view was that a rebound in commodity prices would result in Brazil’s economy improving and its stock market should improve as well.
That call has not come to fruition yet, as shown by the Brazil ETF EWZ being down 21% since that call. And here are 3 lessons I think are important when investing in emerging markets, of which the first will relate to why my call on Brazil has been wrong so far.
1. Changes in currency can have a big impact on results
I would say a central reason why my call on Brazil has been wrong is because of currency. The Real (Brazil’s currency) has been very volatile and has depreciated against the dollar since the slowdown in China started to occur in 2015 along with the commodity bust, which put Brazil in a deep recession. Recently, a trucker strike derailed plans to get the economy back on the path to recovery and sent the currency tumbling again.
What this has meant for my dollar investment is also depreciation… Let’s use an example to see why: say a stock in Brazil was trading for 100 BRL when the USD/BRL rate was at 3.00. I place an $10,000 order, exchaning my dollars for 30,000 BRL and buy 300 shares. In local currency terms, lets say the stock goes up 10%, such that the quoted price is 110 BRL. I should have made $1,000 bucks on my investment, right?
Nope. If the BRL depreciated like it did in the chart above from 3.00 to 3.85, I’d be sitting on a pretty poor return actually, as shown below.
Alas, this would mean even though I was right on stock selection, the currency movements negatively impacted my returns. This is partially why with all the global currency volatility, currency hedged ETFs are launching all over.
Do I advocate for currency hedges? Sometimes. It depends on the time-horizon. A long term investor may look at the levels of the BRL to the USD and see this as a buying opportunity and therefore, you can be right on stock selection AND the currency may be in your favor which would boost returns.
However, I don’t think anyway can really tell me where a currency will be in 10 years, so I won’t opine on that. What I will say is that our return thresholds should be much higher when investing in Brazil than lets say the US or another developed economy like Germany. I don’t know what the currency will do over the next 2-3 years, but what I do know is that the real will depreciate over time relative to the dollar. No one questions that the inflation rate in Brazil will be higher than the US over the long run and that should mean that over time, the real should depreciate relative to the USD.
In sum, you have to be aware of currency, especially volatile ones. You’re taking a risk, so we should get paid for that.
2. Just because you’re buying a company’s stock overseas, it does not mean you are afforded the same protections as the US.
Alibaba’s stock is up 25% in the past year and has ~doubled since IPO’ing in 2014. But did you know that if you hold BABA which trades on the NYSE, you actually don’t own Alibaba at all? China forbids foreign investors from owning certain types of companies. As such, you aren’t really buying Alibaba. You are buying a holding company that has a claim on Chinese subsidiaries profits, but no economic interest. The risk here is that China comes in and says that is not allowed and guess what? You own nothing. The New York Times reported on how China has not actually weighed in on this. You may also want to check out the risk factors of Alibaba’s 10-k entitled, “If the PRC government deems that the contractual arrangements in relation to our variable interest entities do not comply with PRC governmental restrictions on foreign investment, or if these regulations or the interpretation of existing regulations changes in the future, we could be subject to penalties or be forced to relinquish our interests in those operations”.
I don’t mean to pick on BABA here (Tencent, Baidu, JD.com each have this problem as well), but the risk here might be higher than you think. Lots of people would say, “look China is relaxing its command economy and moving more to a free market. They wouldn’t do something like that.”
And to that I say, look at Russia. In the 1990’s, following the “end” of the Cold War, Russia issued privatization vouchers that allowed investors to actually own former State Owned Enterprises. This was a huge step for Russia and it seemed like the old communist power would be relaxing its grip on businesses. But I encourage you to study what happened when Russia deemed it needed to re-control “strategic sectors”. Yuko Oil Company is a fascinating case study.
In a very brief summary, Yuko went to the private markets and quickly adopted transparent rules and practices, became one of the world’s largest non-state owned oil companies, and even had 5 Americans on its board. The company was paying dividends and growing internationally as well.
When Putin came to power, things quickly changed. The CEO of Yukos was arrested for tax evasion and fraud and Yukos was slapped with a $27 billion fine which was higher than its total revenues for the past 2 years. Yukos was forced to break up and its shares were frozen (to prevent a foreign company like Exxon from buying them). Eventually, Yukos declared bankruptcy. Many viewed this as a direct attack on the CEO of Yukos who was gaining political power.
In sum, I think its important to remember these risk factors and not get too comfortable in international / emerging markets that are known to have limited privileges to foreign investors.
3. Active management makes sense in Emerging Markets
So much has been written on active vs. passive investing in the US, it is actually making me nauseous. But I think this is a good topic to end on for this post, because it sums up the previous points here. An active manager can weigh the impact of currency on a potential investment. They can weigh the political changes that are happening in the base of a country. And lastly, they are paid to do work on changes in the tastes of the economy.
One area of research I always try to look for is primary work. That is, if I buy the stock of a company, particularly one oriented to consumers, I want to conduct surveys on what its consumer say about the actual product and understand if that helps or hurts the investment decision in any way. It’s also important to remember that sometimes we take for granted the tidal shift occurring in the U.S. such as Amazon, Netflix, or Apple because we interact with those products and see them on TV everyday. But how can you tell what type of products they are using in India or China without being there? Did you know Netflix and Apple are not the primary sources of products in those countries? They have their own.
Tastes change and they change quickly, so in my view, unless you’re traveling to the country often, you are paying an active manager to do that work. Indexes are backward looking (i.e. they weight the companies that have performed the best in the past at the top in a market cap weighted index), so they do not always calculate the risks mentioned herein. Sometimes they don’t include the entire universe, which can limit returns or at least potential for higher returns.
And as a result, we can see in the chart below that it pays to pay the higher management fee for active. This chart (taken from AllianceBernstein) shows that “70% of active managers in emerging equities have beaten the benchmark over the five-year period ended March 31, 2017, while 66% have outperformed over 10 years, net of fees. On a rolling five-year basis, the percent of active managers outperforming the EM index has never fallen below 50%”.
Hope this was helpful for you. Please let me know if you have any questions or comments.
After reading Principles, by Ray Dalio, this past winter (which I highly recommend as it gave me many, many things to think about) I have been reconsidering my position on being highly underweight fixed income. Perhaps you are similar to me and kept waiting for rates to move up for an attractive entry point.
Now the ten year treasury is hovering around 3% and as I noted previously, is not that far off from long-term averages. Does it make sense to allocate more of our portfolios to fixed income now?
Perhaps you have heard of Ray Dalio’s “All Weather Portfolio” in which he allocates a surprising amount to fixed income, as shown below. His rationale centers on a few factors. One is that by having weighting your portfolio at 80% stocks / 20% bonds is actually heavily weighting “risk”, given the volatility of stocks vs. bonds and for someone like Ray Dalio who is trying to build wealth over the long, long term, performing well in down markets matters. Bonds should go up when stocks go down due to “flight to quality” impact in a down market. The allocation to gold and commodities provides extra diversification, plus these assets perform well during periods of high inflation, whereas bonds will not perform well.
40% long-term bonds
15% intermediate-term bonds
“The principles behind All Weather relate to answering a deceptively straight-forward
question explored by Ray with co-Chief Investment Officer Bob Prince and other
early colleagues at Bridgewater – what kind of investment portfolio would you hold
that would perform well across all environments, be it a devaluation or something
Using portfoliovisualizer.com, I decided to see the results for myself and ran different 3 portfolio cases from 1978-2017.
The first is based on Dalio’s All Weather portfolio, though admittedly, I had to do a 15% allocation to gold as a general commodities fund was not available that far back. I then ran a 60% stocks / 40% intermediate treasuries portfolio and then an 80% stocks / 20% intermediate treasuries portfolio.
Let me first say that it shouldn’t be too surprising that the higher stock portfolio wins out. Stocks have been a terrific asset class over this time period. Its higher risk, so higher return makes sense.
But look at the results of portfolio 1, the All Weather Portfolio. Results over this time period are not too shabby, logging a 9.4% CAGR and growing $10K to $380K. But the really interesting thing to me is the worst year and worst drawdown. The worst year was only down ~4%! Compare that to the stock heavy portfolio of -25% and having a near 40% loss in portfolio value during the year. Makes me think of “Slow and steady wins the race”
This analysis isn’t perfect for a host of reasons. Bonds have been in a bull market for 30 years and were at much higher rates during this time period and subsequently went way down. I do like a quote from the white paper though, in which it states,
“In the US after peaking above 15% in the 1980s, cash rates are now zero. Stocks and bonds price relative to and in excess of cash rates. A 10-year bond yield of 2% is low relative to history but high relative to 0% cash rates. What is unusual about the recent environment is the price of cash, not the pricing of assets relative to cash.”
For further analysis on portfolio outcomes that aren’t tied to back testing, I decided to build a monte carlo spreadsheet analyzing a 50/50 portfolio of stocks and bonds. I then ran 10 random simulations over 40 years to see where the portfolios would shake out. This was pretty simple analysis and I probably should’ve added a component that says, “if stocks are down, then bonds are flat or up”, but decided to keep it random.
Given how high the standard deviation is for bonds, it is no surprise that the highest returning situations are driven by bonds outperforming, but we should also not ignore the simulations where in year 38 out of 40, stocks fall 45%, as shown in scenario 3. Bond provide decent offset to a devastating scenario.
I think the takeaway I have is that bonds / fixed income can make sense in the portfolio, depending on what you buy. So far, all I’ve shown is buying treasuries, but think there are solid opportunities in high yield and municipal bonds which are much more stable than stocks, but provide good returns.
I’ll follow up in another article on a bond fund that I think makes a lot of sense to buy for a pretty attractive return.
I recently got back from an industry conference and my main takeaway was that 2018 could be the year of inflation. What does that mean and how should we position our portfolios?
To start, why do I think inflation will be ticking up this year? Anecdotally, I’ve heard from many employers from this conference that wages are up 20% year-over-year. That is significant! Recall, that wage growth has been one area stuck in low gear since the crisis, even as employment levels have recovered. As wages increase, firms costs increase and also increases consumers’ income to spend more, which helps inflation.
Turning to actual economics, demand-pull inflation occurs when aggregate demand grows fast than supply. When the economy is at near-full levels of employment, as we are now, that leads to increases in price levels. Why do I think demand will exceed supply? For one, consumer confidence averaged ~97 for all of 2017. That is the highest level since 2000, and according to University of Michigan’s economist, Richard Curtin, “only during the long expansions of the 1960’s and 1990’s was confidence significantly higher.” Plus, the stock market is up and setting new records, home prices are up, and while these do not cause inflation, it causes a positive wealth-effect that encourages the consumer to spend more and can buoy economic growth. In other words, these are indirect causes of demand-pull inflation.
I also tend to think cost-push inflation will also occur in 2018. Take oil and its derivatives for example. While not back above peaks, as we sit with it hovering around $60/barrel, that is well above the average levels of 2015 and 2016. Similar to wages, higher costs of other inputs rising leads to higher prices.
There are a few offsets to these inflationary forces, however. The fed is raising interest rates. Higher rates in the US should drive up the value of the dollar, all things being equal. Higher interest rates attract higher foreign investment, which causes the value of the currency to rise, in this case the dollar. This makes US good less competitive on a global scale. On the flip side however, higher inflation in the US relative to other countries will cause depreciation in the USD relative to those with lower inflation. Therefore, the impact of higher interest rates is mitigated by the fact that the US has higher interest rates than some countries, such as Japan or countries in the Eurozone which are combating deflation. The US also has a pretty bad current-account deficit (that is when a country spends more on foreign goods than domestically produced ones). We likely will continue to spend more on foreign trade than we earn, which will decrease the value of the dollar.
In addition, firms in the US will be able to fully expense capex for tax purposes, instead of the depreciation expense for tax deductions. Firms could invest in automation, crowding out labor and keeping wages down. In essence, we shouldn’t underestimate the deflationary impact technology can have. However, I tend to think this will take time.
But if I had to bet, I think inflation will tick up, which will cause interest rates to rise.
So where should I position my portfolio? Let’s start where I do not want to be. If interest rates finally due rise, the one place I do not want to be is low coupon, higher duration bonds and bond proxies (i.e. stocks that are highly correlated to bonds, like utilities and REITs).
I also do not want to be in stocks that have a long tail. For example, some biotech stocks valuations are through the roof based on the expectation in 3-5 years they will come out with a blockbuster drug. As the discount rate increases, these stocks will get crushed considering their earnings are further out. Tesla is another example of this…
On that note, we should consider that the discount rate for all stocks will be increasing. That could hurt the valuations of a lot of names as the S&P grinds higher (e.g. the S&P historically traded at 15x EPS, but now trades at 18x. Could there be a reversion to the mean?).
Where would I invest in these times?I am tilting my portfolio towards commodities. Although they have had a big run in 2017, we are still well below levels seen in 2011 and 2012 for commodities. If inflation ticks up, these have room to run and can serve as a hedge to my equity holdings. Refer to the chart below to see where we sit in the commodities world compared to recent history (chart depicted is the Bloomberg Commodities Index, which is made up of energy, grain, metals, etc.) Full disclosure, I own XLE, the energy ETF, MOO, the agribusiness ETF, and am considering BCX, Blackrock’s resources and commodities closed end fund, which trades at a ~7% discount to NAV and yields 6%.
Second, a tertiary bet on commodities is countries that benefit from rising commodities. I am also adding to my position with exposure to Brazil. Brazil is still coming out of one of the worst recessions it has seen in a long time in addition to a crack down on corruption. As commodities recover, labor improves and consumer confidence builds following the corruption scandals, Brazil could have a multi-year run ahead of it. I purchased both EWZ as well as BRF, which tilts to small cap, consumer stocks in Brazil as a leveraged bet.
Lastly, while I am avoiding REITs since I believe investors who have been starved for yield have driven up valuations, I do like the building products sector. Real estate tends to perform well in period of inflation, supply remains constrained, and we are still below average housing starts since the last recession. Even if interest rates rose 100-200bps, affordability is also at great levels. As such, I think building products is the sector to be in for the US.